Monday, August 20, 2007

There are two defining moments from late last week - an incredible rush to safety, and a washout in terms of market breadth.

There are many ways to watch for extreme moments of risk-aversion. One sign of that came from Rydex mutual fund traders, as they were three times more likely to invest in a "safe" fund than a "risky" one. But in the bigger scheme of things, Rydex funds are small potatoes. The Treasury market is not.

And in that Treasury market, we saw a huge rush to one of the safest of all instruments - the three-month T-Bill. Over a two-day period, the yield on T-Bills dropped by more than 20% (near Thursday's nadir), which means that there was a big demand for those Bills. Like all credit, when demand is strong and supply is restricted, then prices rise and yields fall.

That two-day decline was one of the steepest in five decades. Using data from the Federal Reserve for secondary market rates on T-Bills, I could find only two other times since 1950 that yields dropped so much in such a short period. Those two times were February 24, 1958 and September 17, 2001. Both led to an imminent halt in selling pressure in equities (or very close to it in 2001), and the S&P 500 was about 8% higher a month later both times.

That rush to safety was accompanied by traders dumping shares at a record rate. NYSE volume set a record on Thursday, and the past two weeks have seen several days with volume nearly as high. Large share turnover in the midst of a decline is typically a mark of a bottoming market.

Going back to the 1960's, I looked for any time total NYSE volume was at least 50% above its one-year average for at least five out of the past ten sessions, AND the S&P 500 was at least 5% below it's highest point of the past year. Looking ahead three months, the S&P was positive 90% of the time (92 out of 102 days) with an average return of +7.6%.

Much of that volume was traders wanting to get out of their shares, and selling at any price. By Thursday, a phenomenal 1,132 stocks had hit new 52-week lows, the second-most in history.

Expressed in terms of total stocks traded, that comes out to 33%. There have only been three times in the past 20 years that more than 30% of stocks hit a new low on the same day - 10/19/87, 8/23/90 and 8/31/98. Those were exceptional times to initiate intermediate-term long positions.

Also near a couple of those dates, we saw extraordinary one-day reversals on heavy volume, and brokers exploding out of one-year lows…just like Thursday. Fundamentally, there are many reasons to expect more bad news and possible selling pressure to come. And technically, the markets look quite weak. But looking at some of the intangibles, a good argument can be made that despite some likely short-term testing of Thursday’s low, that testing should succeed and result in a one- to three-month recovery.

The biggest question over the weekend was whether the engineered discount rate cut by the Fed was enough to safely say the lows were put in last Thursday. There are reasons to be skeptical in looking at the market players and the Federal Reserve.

We have been witnessing the phenomenon of deleveraging and if history is any guide this rarely occurs smoothly, or without some effect on the wider economy. It is hard to imagine that what took years to create is over in a few weeks. The ability to slice and dice risk and spread it around has us questioning the vulnerability of the economy.

In addition, there are clear signs that the pain is spreading from hedge funds to banks. The total amount of rescue financing has placed tens of billions of dollars at risk for many of the biggest banks. Most charge nominal fees for the guarantee of liquidity and some banks did not properly reserve for the risk since the prospect of default seemed remote.

Citigroup (C) and JPMorgan Chase (JPM), for example, have guaranteed more than $90 billion of liquidity, or about 5 or 6 percent of their total assets, according to a recent Banc of America Securities report.

State Street(STT), a custody bank, guaranteed about $29 billion, or 23 percent of its total assets.

That has ignited fear that the subprime contagion has spread to the global banking system — and, some suggest, caused the Federal Reserve Board to take action yesterday.

“The Fed is concerned because of the banks’ exposure. The banks are on the hook for potentially tens of billions of dollars,” said Christian Stracke, an analyst at CreditSights, a fixed-income research firm. “That could tighten credit conditions significantly if all that paper is tied up in things that none of the banks want to hold."

Bernanke’s Fed

The perception that the Fed will bail us out is still in the background for many, but if Bernanke turns out to be more like Volcker than easy Al as I wrote on August 13th, then the current Fed will inject liquidity when needed but may quickly remove it when markets stabilize.Mr. Bernanke may not follow in the footsteps of the former Fed chairman and provide what fondly became called the “Greenspan put.” Under that philosophy whenever a crisis brewed Greenspan would slash the fed funds rate and provide cheap money to those who needed it as well as those who used it to add on layers of derivative speculation.

The Greenspan put helped during crisis such as the 1987 stock market crash and the 1998 Long Term Capital Markets hedge fund fiasco, but it also built up a huge speculative fervor and added on layers of risk that would not be there if cheap money had not been available.

Friday’s move by the Fed to lower the discount rate – not the Fed Funds rate made liquidity available to banks and depository institutions. They could borrow against collateral, such as asset-backed securities but the important distinction is that this discount window is not available to the more speculative group such as hedge funds and in this sense is quite different from the insurance that Greenspan provided.

We are going forward confronted with decisions to make both with our portfolios and with daily trading. I am approaching the markets as if I am still walking in a minefield and highly alert as to where I step. Listening for further news from institutions holding subprime debt as well as the language and actions of the Fed will be paramount as to how we navigate this treacherous terrain.

During the day I am trading “light and tight” meaning small positions with tight stops. I still believe we are at the beginning - not the end of a volatile time in many asset classes and we should not get lulled into complacency if markets are calm for a week or two. That said, my other twin always reminds me I am too close to the game and I am reminded of the words from Julian Jessop of Capital Economics as he puts it rather directly: “People in financial markets always think they are more important than the real world.”

Sunday, August 19, 2007

Market Internals and chartpatterns of key indices this past week tell us that Fed's Discount Rate Reduction by 50 bp was immediately viewed as very constructive by our equity markets. While we do not view Thursday SPX low as the final bottom of this leg, DJIA low print on Thursday, for all practical proposes, came in at our first support level (12,500).

We expect this low to be tested as Fed's combat of the SubPrime Mortgage Debacle is still an ongoing event. Ideally this test (and its accompanying vol retest) should come, ceteris paribus, in about 2 to 4 weeks from now. That process will build the tradable bottom which we have been looking for. We plan to go long then and hold it into Xmas.

Here are the nuts and bolts from this week's action. The sell off was caused by loose credit and poor lending decisions. Defaults had a cascading affect and they started a run on short-term debt instruments. That liquidity crunch culminated when T-bill rates dropped 1% this week. That type of move is almost unprecedented.

The squeeze spilled over to brokerage firms and they raised margin requirements to control risk. Instantly, hedge funds that utilize quantitative analysis were forced to liquidate their holdings. They employ a long/short portfolio strategy where they buy value and sell "fluff". Theoretically, they are market neutral. Many financial institutions view this as a conservative strategy and they allow these hedge funds to leverage up to an 8:1 ratio. When brokerage firms change the rules, the hedge funds have to pare their holdings. That is why we saw so many quality stocks get trashed this week. Companies that just announced earnings and raised guidance were pummeled even though they trade at low P/E's.

The sell off Thursday was exacerbated by option expiration sell programs. Regardless, the market staged an impressive intra day reversal without the help of the Fed. Friday morning before the open, the market was down 25 S&P 500 points in response to overseas declines. As the opening approached, the futures were only down 8 points. Clearly, we were near a short-term low. At 7:15 a.m. CST, the Fed lowered the window discount rate to avert a liquidity crunch and the rally was on.

The Fed’s action allowed financial institutions to pledge securities and borrow cash. This allows companies to meet their short-term obligations without having to dump their holdings at artificially depressed prices. The Fed has not had to use this tool for many years.

There are many other leveraged “conservative” strategies like this and when liquidation is forced, the market is thrown out of whack. The yen-carry trade is a widely-cited example. The most important thing to remember is that the macro business conditions remain intact. The adjustment process needs to run its course before everything can return to normal.

The Fed has conveyed that they are aware of current market forces and they are on alert. Next week the economic releases are very light. Retailers make up the majority of earnings announcements and dismal results are priced in. The market has staged back-to-back late day rallies and I believe it will follow through next week. If it can get above SPY 146, that would be a short-term bullish sign.

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Fari Hamzei is frequently quoted by Benzinga, StocksNJocks, CNBC, Bloomberg, FoxBusiness and RealMoney. His book, Master Traders: Strategies for Superior Returns from Today’s Top Traders, published by John Wiley & Sons in October 2006, immediately become a bestseller on Amazon trading books space. Three times, Fari has been the featured advisor on Timer Digest monthly newsletter when each time he was ranked FIRST in the Nation for the previous 12 months among 150 market timers. More recently, in August 2015, he was ranked SECOND in the country, then moved to FIRST place in October 2015. In December, he briefly was ranked SECOND and since first week of January 2016, he has been ranked ONE in the Nation till present.

From 2006 to 2011, once or twice per year, Fari has taught his Proprietary Sentiment Indicators at The Options Institute of CBOE. And, he often shares his methodology on CBOE Options Hub.

Fari is a graduate of Princeton University with a BSE degree in financial engineering, and studied financial derivatives with Options Theory luminaries such Jack Shelton, Ed Thorp, Robert Geske, Richard Roll & Robert Whaley (inventor of original VIX) at UCLA Anderson Graduate School of Management. He was manager of the Operations Analysis Dept and then was promoted to the director of Strategic Planning at Northrop Grumman Corporation's Aircraft Group after being recruited only 5 years earlier from college. He also served for eleven years on the Board of Directors of Electronic Clearing House (ECHO), now an Intuit company (INTU).Read Fari's Recent PostsBrad Sullivan is a member of both MERC & CBOT Exchanges, and trades for his own hedge fund in Chicago. His comments posted in our HFT Premium Chatroom, is read each day by many active index, debt and commodity futures traders.Read Brad's Recent PostsMark "SPO" Esposito aka The Admiral, has traded as a sole proprietor and as a partner in the Designated Primary Market Maker (DPM) structure at the CBOE for 27 years. During the late 80’s “SPO” was regarded as one of the most active and largest traders on the CBOE Floor. Experiences like trading the crash of 1987 and the tech bubble burst of 2000 proved invaluable in understanding option volatility. Extending those experiences in mentoring of many individuals helped develop many successful traders during his tenure. While serving in the CBOE committee structure he was integral in the CBOE transition from open outcry to hybrid (open outcry + remote market making). He was then recruited by OneChicago as its Managing Director of Business Development. After 12 years at OneChicago, in mid-December 2015, he joined HA to run our HFT Options Trading. Today, strategy and trading analysis are part of his many active roles.
Michael Blythe's trading experience began at the beginning of the 2nd Iraq War in 2003 as an intern for an institution on the AMEX floor that would later become part of Charles Schwab. From there he became responsible for hedging an agricultural operation until 2008, when a month before the Lehman Brothers fall, he accepted a role to manage fixed income trading for an 'accredited investor' trust which periodically took him to the CBOT floor to work with seasoned strategists. Since then he has gained education and experience working with one of the featured traders in the Market Wizards series and is currently completing a degree from the London School of Economics.Read Michael's Recent PostsPirouz Hendi graduated from California State University Fullerton with a BA in Business Marketing. Pirouz started his career in the financial industry at Prudential Securities in 1999 as a licensed Stock broker after successfully completing series 7, 63 and 65 securities exam up until 2003. Pirouz has been an independent trader in the equities market since 2007 with primary focus on individual stocks and ETFs. Pirouz has successfully completed the beginner level of CBOE option courses and is planning on completing their intermediate and advanced level courses as well.
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Read Jeffs's Recent PostsFil Zucchi is the founder and manager of Zebra Investment Advisors LLC, a Virginia registered investment advisor, and Zebra Fund, LLC, a long/short hedge fund. Before founding the Zebra companies, Fil managed individual long/short accounts. Prior to that, he was a bankruptcy and commercial litigation attorney in a Washington, D.C. law firm. Fil was a contributor to theStreet.com Street Insights. Fil is also currently involved in his family’s commercial real estate development and management operations.Read Fil's Recent PostsDavid Miller, a contributor to Master Traders, is the CEO and co-founder of Biotech Stock Research, LLC, publisher of Biotech Monthly. Launched in October 2001, Biotech Monthly combines a monthly newsletter format with alerts on breaking news on more than two dozen development-stage biotechnology companies under coverage. His firm is one of the few independent research firms in that it accepts no money from the companies it covers, does no outside consulting in the biotech space, runs no mutual or hedge fund, and is 100 percent subscription-supported. In addition, David was CEO of a successful technology company and a university professor.Read David's Recent PostsFrank Barbera, CMT, a contributor to Master Traders, is a co-manager of the Caruso Fund, a $35 million hedge fund that seeks to make gains trading precious metals, stocks, and currencies. He began his career in the early 1980s working with John Bollinger, Bill Griffith, and Susan Herrera at Financial News Network in Los Angeles. After FNN, Frank spent 10 years as an on-air market analyst for KWHY-TV in Los Angeles. His first money management position was at the Kavanaugh Fund in Santa Monica, a hedge fund subsidiary of Goldman Sachs. His technical work in gold and gold stocks is considered among the best in the industry.Read Frank's Recent PostsTim Ord, a contributor to Master Traders, is the president, editor and publisher of The Ord Oracle, established in 1990, which is an electronic advisory newsletter that recommends S&P, NASDAQ, and gold stocks trades. He is frequently listed in the top 10 market timers in the country. Timer Digest ranked Tim No. 5 in gains for the S&P and No. 2 for gold timer in 2004. He has more than 25 years of trading experience and placed fourth nationally in the option division in the United States Trading Championship in 1988.Read Tim's Recent Posts